FHA May Be Next in Line for Huge Bailout: Delisle and Papagianis

July 26 (Bloomberg) -- The nationwide decline in house
prices has created a vacuum in the U.S. mortgage market. Private
financing for home loans has all but dried up and the U.S.
government is now guaranteeing almost every new mortgage. Fannie
Mae and Freddie Mac have received most of the media’s attention,
but policy makers need to focus on the third leg of the housing-support stool: the Federal Housing Administration.

The FHA has some major accounting problems. Left
unaddressed, they could spook the markets, lead the FHA to seek
a federal cash infusion and further enrage taxpayers. These
outcomes can be avoided -- but only if policy makers are more
transparent about the risks involved in guaranteeing mortgages.

The FHA provides private lenders with a 100 percent
guarantee against defaults on home mortgages that meet certain
underwriting criteria, such as a minimum down payment and credit
score. Traditionally, the FHA has served first-time homebuyers
and low- to moderate-income families who pay an insurance
premium for this loan guarantee.

As private-financing options have disappeared, the role of
the FHA has grown. Its market share has increased to about 30
percent today from 3-4 percent in 2007. That’s because the
agency is now practically the only game in town, accepting
borrowers with down payments of as low as 3.5 percent. As the
last few years have made clear, sizable down payments -- or
“skin in the game” -- are the key to avoiding defaults in the
near term and to achieving a stable housing market in the long
term.

FHA’s Bottom Line

So how has the FHA fared financially in serving borrowers
with low down payments? As the housing bubble burst in 2007, and
the number of mortgage-related defaults started to climb, the
FHA’s capital reserves declined to $3.5 billion from $22
billion.

This means that the FHA is on the verge of requiring a
bailout to support its outstanding mortgage guarantees, which
are projected to exceed $1 trillion in 2011.

The credit quality of FHA lending can be improved with
better underwriting standards, such as requiring higher down
payments and premiums. Unfortunately, it’s difficult to sound
the alarm because flawed accounting measures show that new FHA
loans will be profitable for the government. As a general rule,
each year the government sets insurance premiums high enough to
give the appearance that they will more than cover any losses
from homeowners who default.

Budgetary Illusion

But no one should take comfort in the FHA’s projected
profit. It’s purely a budgetary illusion.

According to the Federal Credit Reform Act of 1990,
federal-budget analysts must strip out any costs that the
government incurs when it bears market risk in guaranteeing
loans, including mortgages. Market risk is the likelihood that
loan defaults will be higher during times of economic stress and
that those defaults will be more costly. Excluding costs for
market risk is particularly irresponsible at a time when
foreclosure rates are elevated and doubts remain over whether
home prices will fall further.

If the rate of loss on the FHA’s new guarantees ends up
higher than expected, that will probably be because the overall
economic recovery has stalled. In such a scenario, any entity
guaranteeing mortgages -- be it the taxpayer-backed FHA or a
private company -- will suffer bigger-than-expected losses.

Taxpayer Risks

Skeptics might dismiss warnings about the FHA’s ballooning
market share. They would defend the government’s current
accounting rules and argue that the growth in FHA loans (at the
expense of private-sector lending) is a perfectly logical policy
goal. In their view, the government is a more efficient provider
of mortgages because it can borrow at lower interest rates than
any private financial institution.

What’s missing from this analysis is that the government
enjoys low borrowing costs only because it can shift market risk
onto taxpayers.

Put another way, there is only one reason why investors
lend to the government at lower rates than they charge private
mortgage insurers, even if they all insure identical mortgages:
The government can call on taxpayers to repay bondholders if FHA
loans result in higher-than-expected defaults. Few taxpayers
would choose to bear that risk free of charge.

Rewriting the Rules

Some lawmakers understand this and are working to change
the government’s accounting rules to include market risk. At the
request of Representative Paul Ryan, a Republican from
Wisconsin, the Congressional Budget Office recently took the
official budget estimate for new FHA loans and added in the cost
of market risk that taxpayers bear in guaranteeing the
mortgages.

Under this more comprehensive methodology, the CBO
determined that FHA loans would swing to a loss of $3.5 billion
from a projected profit of $4.4 billion next year. In a 10-year
budget window, this could mean a difference of $50 billion to
$70 billion, depending on market conditions.

Accounting issues often seem arcane or even trivial. But
the growth in FHA lending has turned a seemingly small problem
into a large taxpayer vulnerability. The current accounting
rules will also make it harder politically to shift some of the
housing market back to the private sector. Congress should own
up to the full costs and risks that taxpayers bear to guarantee
mortgages.

The last time Congress delayed action in this area,
taxpayers got stuck bailing out Fannie and Freddie -- at a cost
of more than $160 billion and rising.

(Jason Delisle is a project director at the New America
Foundation. Christopher Papagianis is managing director of
Economics21 and a former special assistant for domestic policy
to President George W. Bush.)